Defined benefit and defined contribution are very different types of pension plans, and you might be asked to choose which plan you want to participate in for your retirement savings when you start to work at a new company. While fewer companies are offering a defined benefit plan, it is still important to understand the difference between a defined benefit and defined contribution pension and how that difference may affect your retirement savings plan.
Defined Benefit Plan
A defined benefit plan is set up by employers to pay a fixed amount to eligible retired employees. An employer can set the criteria that determines an employee’s eligibility -- usually the length of employment. At retirement, the employee receives a fixed annual payment based on a formula taking into account the number of years of employment and salary. The expense of a defined benefit plan is solely the responsibility of the company. How much the company must contribute each year to the pension plan is calculated using actuarial tables and company statistics, such as the number of employees, salaries and length of employment.
Defined Contribution Plan
A defined contribution plan requires that an account be set up for each individual employee. Contributions are made to this account based on the plan documents. Instead of the contributions being based on your expected retirement payout, as in the defined benefit plan, the amount that an employer and/or employee can contribute is typically a percentage of the employee’s salary. Along with the contribution, the final amount of monies in the account is influenced by employee decisions on how the money is invested.
Pros and Cons to Employee of Defined Benefit Plan
With a defined benefit plan, you receive a fixed payout that can be either in the form of a monthly check or a lump sum. How much you receive has nothing to do with how well the money was invested. The payout is based on the aforementioned formula using factors such as your earnings and length of employment. There is no cost to the employee and the payout is guaranteed. On the negative side, the employee has no input in how the funds are invested and some defined benefit plans do not offer adjustments for inflation. Plus, if you have not worked at the company long enough to become vested in the retirement plan, you leave with nothing when you leave the company.
Pros and Cons to Employee of Defined Contribution Plans
Unlike a defined benefit plan, you are in control of your money. You decide how much to contribute to the plan and how to invest it. If you leave the company, your money comes with you no matter how long you worked there. It is possible to have more money at retirement age than under a defined benefit plan based on the investments you choose. On the negative side, your retirement income depends on what you are able to save and how well you have invested the monies in your account. If the money is invested too conservatively, it may not grow fast enough to keep up with inflation. The retirement benefits are not guaranteed. The final balance in your retirement plan is based on the outcome of your invested contributions.
Corporate Move to Defined Contribution Plans
More and more companies are eliminating defined benefit plans by freezing them for current employees -- or simply terminating them -- and not offering them to new employees. The reason for this change is simple: the expense to the company of a defined benefit plan. By switching to a defined contribution plan, part, if not all, of the cost of the company’s retirement plan now falls on the employees.